(Chicago) Chairman and CEO Joe Mansueto kicked off Morningstar’s 2012 Investment Conference in Chicago on June 20 by noting the presence of 1,850 attendees, 75 journalists and 200 exhibitors at this year’s show. He then introduced the opening keynote speaker, famed Franklin Templeton fixed-income manager Michael Hasenstab, by highlighting Hasenstab’s status as Morningstar’s 2010 fixed-income manager of the year.
“When Michael began at Franklin Templeton, he managed $100 million,” Mansueto added. “Today, he is responsible for a group that oversees $160 billion in assets. The fund that he specifically manages, the Templeton Global Bond Fund, is second only to PIMCO Total Return in its size.”
The soft-spoken Hasenstab then took the stage and quipped, “We’re in a period of incredible uncertainty. I’d like a boring summer for a change, but it doesn’t look like it will happen. How should we separate the noise from the really key issues? More importantly, should we panic?”
A good argument could be made for panicking, he said, especially if you think the European Union will break up and China will have a hard landing; global markets could not absorb either event and “it would make Lehman look like a warm-up.”
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“But if we’re able to stay calm, we’ll need to think through the ‘tectonic shifts’ happening in the world that have largely been masked by the crisis in Greece,” he noted.
As for inflation, “We have this unconventional monetary policy at central banks, which are printing money,” he warned. “If this is such a good idea, why weren’t we doing it all along? Between 25% and 30% of global GDP has been printed at banks, so this is by no means at the fringe. We need to think about the consequences of those actions, which will not be felt as much in the United States [or] Europe, rather in the rest of the world.”
The risk to emerging markets, specifically, is a flood of capital resulting in a “monetary tsunami” in those countries, which will present a major challenge. Here in the United States, the debasing of the dollar could lead to an asset-base distortion that would put upward pressure on commodities, in Hasenstab’s view.
But all this risk and uncertainty provide opportunity, he concluded. “In emerging markets, the tables have turned. Those countries that were once high credit risks, like Indonesia, now look very good, so you should upend your traditional risk models. Also, the United States, Japan and Europe printed money, and don’t look so good. But non-leveraged countries in the rest of the world weren’t printing money, didn’t have an asset bubble and as a consequence didn’t have to deleverage. We like to get yield with little or no credit or interest-rate risk. This is why Asia currently looks so good.”
“Investors are asking about stocks, corporate debt and so-called hybrid investment,” Michael Herbst said on June 21. “But with volatility, yield and equity returns being what they are, those decisions have been turned on their heads.”
Herbst, Morningstar’s associate director of fund analysis, hosted a panel of high-profile fund managers for the general session of the company’s annual conference. Featuring PIMCO’s Mark Kiesel, Invesco’s Meggan Walsh and Don Yacktman of Yacktman Asset Management, the panel touched on each manager’s investment philosophy and how they identify potential red flags, especially when investing across capital structures.
Herbst began by asking the panel what they are looking for “across the capital structure fence?” Yacktman, an equity manager, said he “tends to look at equities in the same way we look at bonds. If we are to hold on to them for a long time, what type of risk and return would we have? It’s almost like holding a bond to maturity.”
Walsh added that Invesco focuses on the potential for capital appreciation, and that she “spends a lot of time on figuring out the potential downside,” which, given that she’s a portfolio manager, was reassuring for the audience to hear.
Kiesel said PIMCO managers take a top-down approach, beginning by asking themselves what areas of the world they feel will perform best. “Currently, we feel it’s the United States and Asia,” he said, partly agreeing (Asia) and disagreeing (United States) with Franklin Templeton’s Hasenstab. “We then consider a particular company’s enterprise value and where on the risk/reward spectrum we will then perform best. It’s really very simple; it’s the best part of the globe, the best sector in that part of the globe and then where we should invest in the capital structure.”
Herbst then asked about the managers’ red flags. “We favor businesses with a high return on real assets, so we look to the left side of the balance sheet,” Yacktman said. “We look to avoid low return, low turnover of assets and companies with off-balance sheet issues like pensions. We feel pensions are the wrong way to fund retirement.”
Kiesel noted that most company balance sheets are healthy at the moment, as capital market have “been open” for the past three to four years. “Credit might not be available for governments, but it sure has for companies,” he said. “So we look at the stress-free cash flow for the company throughout an entire business cycle.”
Herbst then asked the panel about their process for evaluating company management teams, which he said was one of the most frequently asked questions from investors. Kiesel said PIMCO travels frequently to visit companies at their headquarters and specifically asks executive teams about their top three priorities.
“For instance, banks are currently building capital, which means they’re not equity friendly and are running a conservative business because governments are trapping capital inside. This means it’s a good investment for bondholders. So we’ll get on a plane, meet the managers and ask them about it.”
Walsh said it’s important to “watch what managers do, not what they say,” a point to which Yacktman emphatically agreed. “They’ll give you standard answers to your questions,” she said. “We want to see a proactive method for how they responsibly handle their cash on their balance sheets. Right now, a lot of cash is trapped overseas and managers are looking to make acquisitions in order to grow. But these acquisitions might not be good fits. So we keep their feet on the ground.”
“Behavioral patterns are instructive,” Yacktman added. “I once spoke with a CEO who said, ‘My people are always trying to get me on CNBC. I don’t want to go on CNBC. The people that watch are not our investors, and I don’t want the investors that do watch. It would be a total waste of time.’ That was music to my ears. I said, ‘Wow, this guy is focused.’”
As for where the managers are finding alpha from a valuation perspective, Walsh named the housing and homebuilders, consumer discretionary, transportation and lodging sectors. Kiesel likes energy, which he said is a good area for equity and debt investors. He agreed with Walsh that housing has hit bottom, and as a result likes Weyerhaeuser for its timber exposure. Lastly, he pointed to gaming in China.
“If you look at Macau, it’s doing five times the business of Las Vegas,” said Kiesel. “Five years ago they were essentially even. So this is another area that is good for both equity and debt investors.”
“We’re not going to play the loser’s game,” David Rolfe, chief investment officer of St. Louis-based Wedgewood Partners, said upon being named an SMA Manager of the Year in April 2011. “Instead of trying to time the markets and getting sucked into short-term volatility, we take a long-term view and let the markets work for us. Too many of our competitors try to do otherwise, and we refuse to play that game. That, quite simply, is our investing philosophy. ”
Fast forward a year, and there’s not been much change. That adherence to the philosophy in good markets and bad is one reason for Rolfe’s success, and why he’s now celebrating his 20th year with Wedgewood. “I started with $10 million to $15 million in assets under management,” he recalled at the Morningstar event on June 21. “Today we have $1.7 billion in AUM.”
“To outperform an index, we believe that our portfolios must be constructed as different from an index as possible,” explained Rolfe. “Thinking and acting like business owners reduces our interest to those few businesses which are superior. Both of these views lead to our focused (concentrated) approach.”
So far, this philosophy has “worked through complete business cycles,” he said. “We don’t believe we have an informational advantage. We look for 20 good portfolio finds where the valuations make sense. In this way, clients don’t have to sacrifice growth to get value and vice versa.”
As for the current situation in Europe, economic issues here in the U.S. and everything else that’s happening, Rolfe wasn’t all that concerned, at least not from an investment standpoint. “As the market climbs that classic wall of worry, it represents opportunity,” he said, “especially for a concentrated portfolio like ours.” And concentrated it is, with only 20 companies allowed at any one time, a number which only 2% of all money managers are able to claim, he said.
Rolfe admitted that a possible “Achilles heel” to such a concentrated portfolio is that it’s “always one day away from an earnings disappointment.” But if he’s done his homework, he added, he shouldn’t be surprised.